Are Chinese stocks finally cheap enough to buy?

Why Chinese stocks are underperforming

“Chinese stocks have been trading at attractive valuations for some time, but valuation alone has not been enough of a reason for investors to return to Chinese stocks, despite strong earnings growth on an aggregate level,” said Wenli Zheng, the company manager. T. Rowe Price China Evolution Equity Fund, in an interview with Morningstar.

“There is greater uncertainty eroding investor confidence. Domestic investors are increasingly cautious, after seeing their wealth decline due to falling property prices and weak stock markets, many people are keeping their money in bank deposits,” Zheng continues. “We believe investors are waiting for a stabilization of the economy and greater clarity on government policies before being drawn back into a cheap market where many companies continue to deliver relatively high levels of earnings growth.”

“After three years of a bear market, nobody believes in China anymore,” James Cook, head of strategy at Federated Hermes China Equity Fund, told Morningstar in an interview. The Federated Hermes manager, however, points to the recent increase in dividends and buybacks as a factor that could drive the recovery. “Not only do they provide strong valuation support, but they also make a compelling case for equity investment in a rate cut environment. It’s worth bearing in mind that while other countries are experiencing inflation, China is witnessing deflation,” says Cook.

Economic developments holding back Chinese stocks

The world’s second largest economy is still struggling to recover from a downturn in the Covid era and its aftermath. Despite the stimulus implemented by the government to revive domestic demand, China’s gross domestic product in Q2 rose a modest 0.7 percent from the previous quarter, when market expectations pointed to at least 1.1 percent growth. The GDP growth trend thus fell to 4.7% compared to 5.1% in the consensus.

According to Jian Shi Cortesi, Asia/China growth equities investment director at GAM, the crisis in the real estate sector triggered by the Evergrande default had a huge impact in this regard. “However,” Cortesi writes in a note published on September 2, “it is important to differentiate the current situation from the 2008 financial crisis in the US. China’s banking system has shown resilience, and the challenges have been mainly concentrated among developers rather than mortgage lenders. implicit.”

In the future, however, there will be other sectors that could have a positive impact on GDP. “We have identified a multi-faceted shift in China’s GDP growth for 2024,” says Cortesi. “Digitalization is emerging as a key force, expected to boost GDP by around 3.3%. The shift to green energy sources, including solar power, wind power and electric vehicles, is expected to produce an increase of 1.7%. Meanwhile, consumer spending, particularly in travel and restaurants, is expected to contribute 0.4%. In contrast, real estate and related industries currently exert a 1.4% drag on GDP growth.”

China in transition, not in decline

“China is going through a prolonged down cycle and the current outlook remains uncertain,” according to Federated Hermes’s Cook. “The risks are well known: slowing growth, continued tensions with the United States, low consumer confidence caused in turn by a weak housing market, anemic private sector investment and rising local public debt. So far, the government’s response has been However, we believe that the country is in a necessary transition phase and not in a long-term decline”, continues the manager.

“This change in the economic mix should in turn lead to better returns for business. We remain optimistic that China can successfully transform its economy, although it will take time and will never be painless,” Cook says, adding that “widespread pessimism about the economy and markets appears excessive.”

“The government has announced several stimulus measures, but none have yet been as effective as expected,” Theresa Zhou, manager of the Fidelity Sustainable China A Share Fund, told Morningstar last week. “This shows a government reluctance to aggressive stimulus, but rather a focus on incremental policies and economic transformation. This has severely affected market sentiment.”

Beijing’s goal is clear: to start the transition from “growth at any cost” to “high-quality growth.” To achieve this, the government aims to shift economic growth away from traditional low-return sectors such as infrastructure and real estate and towards consumer and high-tech and high-value-added industries.

“Policymakers have stepped up supportive policies for this struggling market, but these policies are not intended to kick-start a renewed acceleration in economic growth. Instead, the aim is to engineer a stabilization of ownership to facilitate a continuous, multi-year transition to a new growth model driven by peak consumption and production,” according to Zhou.

Contrarian bet or value trap?

And here the market is divided between those who think the Chinese market is too good annoyed the opportunity to move up and those who only see it as a value trap.

If a good number of international traders consider China to be “uninvestable”, there may be good reason. Global investment flows appear to support this, with up to US$17.1 billion drawn from China’s open-ended equity funds by investors around the world over the past 12 months, including funds exposed to Equity.

But not everyone shares this opinion.

“We believe that Chinese stocks are attractive in the medium term and that rather than trying to time the market, investors should use fundamentals and valuations as a guide,” says T. Rowe Price’s Zheng.

“The Chinese market is huge and hugely diverse. There is a huge divergence of valuations and growth prospects across industries. Many companies are doing well and trading at attractive valuations. The deleveraging process, while painful, is cyclical in nature and there is room for strong performance once the economy stabilizes.”

Fundamentals are key

Fidelity’s Zhou “would recommend that investors focus on bottom-up opportunities in high-quality stocks with strong fundamentals that have been hurt by the indiscriminate sell-off.”

“We are happy to own companies that we believe are mispriced and will wait patiently, often collecting dividends while we do it,” says Federated Hermes’s Cook. “Currently, there is no shortage of such companies in China. While China continues to face headwinds, the current risk-reward trade-off remains a very attractive proposition for investors.”

“Overall,” continues Cook, “we believe Chinese equities are a fertile hunting ground for contrarian investors and – in light of the remarkably attractive valuations on offer – we’re optimistic that investors should enjoy potentially pleasing performance over any reasonable horizon long term. .”

Where to find opportunities among Chinese stocks

But in which sectors are the most attractive opportunities for investors in China today? “We continue to find companies that deliver strong growth regardless of the economic environment, for example online music, shopping mall operators, online recruitment,” Zheng says.

“Another theme I’ve tilted the portfolio towards recently is finding companies that are well-placed to take advantage of growth opportunities that arise from cyclical revivals in their industries or supply constraints or new product cycles, making them less dependent of the economy in general.” Zheng continued. “For example, the shipbuilding industry has been through several years of reduced supply, so the survivors are benefiting from an increase in demand. Some of the shipbuilders we own have their shipyards filled with orders until 2027.”

“Low-penetrated consumer industries such as sportswear and cosmetics are poised for long-term expansion driven by growing domestic brands and increasingly sophisticated shoppers,” says Zhou. “Despite headwinds, stable growth sectors such as gaming, education and experiential consumption such as travel are still thriving,” she continues.

Cook, on the other hand, believes that “exporters that are globally competitive companies that focus on the domestic market, in a more consolidated industry with stronger price discipline, are better positioned in the current environment.” Currently, he explains, “we have no banks or real estate developers in the portfolio, and many of our holdings have substantial and growing businesses outside of China, which help mitigate currency risk. Instead of owning direct properties, we currently own other proxy companies. that provide macrocyclical exposure – such as cement stocks”.